What is the Bond?

A bond is a long-term contract under which a borrower agrees to make payments of

interest and principal, on specific dates, to the holders of the bond. In another word bond
represent a long term debt from issuer’s point of view and a security from holder’s point
of view.
The value of the bond is affected by the following:-
 Face value:  which will be repaid back at maturity date
 Coupon Rate:  interest rate of the bond and compared to market rate
 Tenor :  No. of Years till maturity

Illustrative Example:
On January, 2003, ABC co. borrowed $50 Million by issuing bonds over 10 years, Face
Value $1000 @ 6% coupon rates per annum. In exchange it promised to make annual
interest payments and to repay the $50 Million on a specified maturity date (January
2013, which is after 10 Years).
Bonds are classified into four main types: Treasury, corporate, municipal, and foreign.

1. Treasury Bonds
Treasury Bonds referred to government bonds since it’s issued by the U.S. federal
government. It is reasonable to assume that the federal government will make good on its
promised payments, so these bonds have no default risk. Because it is guaranteed by
federal government however Value of the bonds itself May be decline when interest rates
rise in the market.

2. Corporate Bonds
Corporate bonds indicate that bond is issued by corporations but corporate bonds are
exposed to default risk if the issuing company gets into trouble or Bankruptcy, it may be
unable to make the promised interest and principal payments. Different corporate bonds
have different levels of default risk, depending on the issuing company’s characteristics
and the terms of the specific bond. Default risk often is referred to as “Credit Risk” the
larger the default or credit risk, the higher the interest rate the issuer must pay.

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3. Municipal Bonds (Munis)
Municipal bonds are issued by state and local governments. Like corporate bonds, have
default risk. However, (Munis) offer one major advantage over all other bonds: the
interest earned on most municipal bonds is exempt from federal taxes and also from state
taxes if the holder is a resident of the issuing state consequently, municipal bonds carry
interest rates that are considerably lower than those on corporate bonds with the same
default risk.

4. Foreign Bonds
Foreign Bonds are issued by foreign governments or foreign corporations so foreign
corporate bonds are exposed to default risk, in addition to currency risk if the bonds are
denominated in a currency other than that of the investor’s home currency. For example,
if a U.S. investor purchases a corporate bond denominated in Japanese yen and the yen
subsequently falls relative to the dollar, then the investor will lose money, even if the
company doesn’t default on its bonds.

Key Features of a Bond

1. Par value: Face value of the bond i.e. amount that be paid at maturity date.
2. Coupon: Stated interest rate Multiply by face value to get dollars of interest
(Coupon could be Fixed or Floating but generally is fixed)
3. Maturity: Number of years until bond must be repaid back.
4. Issue date: Date when bond was issued.
5. Default Risk: When the issuer will not be able to pay interest payment (Coupon) or
Principal Payments.
6. Callable Bonds: when the interest rates decline in the market, the issuer may
payback the value of the bonds before its maturity, therefore, borrowers are willing to
pay more, and lenders require more, on callable bonds.

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7. Redeemable Bond
A redeemable bond gives the investor the right to sell the bond back to the issuing
company at a previously specified price. This is a useful feature (for investors) if
interest rates rise or if the company engages in unanticipated risky activities.

8. Convertible Bonds
Convertible bonds are convertible into shares of common stock, at a fixed price, at the
option of the bondholder. Convertibles have a lower coupon rate than non-convertible
bond, but they offer investors a chance for capital gains in exchange for the lower
coupon rate.

9. Call provision
Most corporate bonds contain a Call Provision, which gives the issuing corporation the
right to call the bonds for redemption. The call provision generally states that the
company must pay the bondholders an amount greater than the par value if they are
called. The additional sum, which is termed a Call Premium, is often set equal to one
year’s interest if the bonds are called during the first year, and the call premium decrease
at a constant rate annually.

10. Sinking Funds Provision

Sinking fund provision facilitates to buy back the issued Bonds through 2 ways:-
A. The company can call bonds for redemption at par value for a certain percentage
of the Bonds each year according to serial number of bonds or by a lottery
administered by the trustee. (Amortization).
B. The company may buy the required number of bonds on the open market.

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 Bond Ratings Provide One Measure of Default Risk

Investment Grade Junk Bonds

Moody’s Aaa Aa A Baa Ba B Caa C
S&P AAA AA A BBB BB B CCC D

Bond Ratings and Bond Spreads

Long-Term Bonds Yield Spread
U.S. Treasury 5.25%
AAA 6.26 1.01%
AA 6.42 1.17
A 6.54 1.29
BBB 6.60 1.35
BB 7.80 2.55
B 8.42 3.17
CCC 10.53 5.28

Annuity
Annuity is a series of equal payments made at fixed intervals for a specified number of
periods. For example, $100 at the end of each of Month or year for the next three years,
and they can occur at either the Beginning or the End of each period.

A. Ordinary Annuity
If the payments occur at the end of each period, the annuity is called an ordinary, or
deferred, annuity.

B. Annuity due
If payments are made at the beginning of each period, the annuity is called an annuity
due.

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The Value of a Bond
The value of a bond is found as the present value of an annuity (the interest payments)
plus the present value of (the principal). The bond is evaluated at the appropriate periodic
interest rate over the number of periods for which interest payments are made.

Example (1)
ABC Company issued a bond with face value for $1000, paid annual 10% coupon and 3
years to maturity, what is the value of ABC bonds today if the required rate of return is
12%.
Answer:
Coupon = 1000x10%= $ 100

PV = 100 + 100 + 100 + 1000

2
(1.12)1 (1.12) (1.12)3 (1.12)3

Ordinary Annuity table PV table

Interest = 12% & N= 3 Interest = 12% & N= 3

PV = 100 X 2.40183 + 1000X 0.71178 =

PV= 240.18 + 711.78 = 951.96 ≈ $ 952

Suppose that maturity date is only 2 Years, what will be the value of ABC bond?

PV = 100 + 100 + 1000

(1.12)1 (1.12)2 (1.12)2

Ordinary Annuity Table PV Table

Interest = 12% & N= 2 Interest = 12% & N= 2

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PV = 100X 1.69005 + 1000X0.79719
PV = 169 + 797.19 = $ 966.19≈ $ 966

Suppose that maturity date is only 1 Year, what will be the value of ABC bond?

PV = 1100 = 982.14 ≈ 982

1.12

Suppose that maturity date is only 3 Years, but required rate of return is 8%, what will
be the value of ABC bond?
PV = 100 + 100 + 100 + 1000
(1.08)1 (1.08)2 (1.08)3 (1.08)3

Ordinary Annuity table PV table

Interest = 8% & N= 3 Interest = 8% & N= 3

PV = 100X2.57710 + 1000X0.79383
PV = 257.71 + 793.83 = $ 1051.54 ≈ 1052

Suppose that maturity date is only 2 Years, but required rate of return is 8%, what will
be the value of ABC bond?

PV = 100 + 100 + 1000

(1.08)1 (1.08)2 (1.08)2

Ordinary Annuity table PV table

Interest = 8% & N= 2 Interest = 8% & N= 2
PV= 100X1.78326 + 1000X 0.85734

PV = 178.33 + 857.34 = $ 1035.67 ≈ 1036

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 Suppose that maturity date is only 1 Year, but required rate of return is 8%, what will
be the value of ABC bond?

PV = 1100 = $ 1018.52 ≈ 1019

1.08

When the RRR Decreased Value of the Bond Increased

Required Rate of Return RRR @ 12% RRR @ 8%

Years
3 952 1052
2 966 1036
1 982 (+) 1019 (-)
When we are approaching maturity date, The value of the bond will approach its Face Value

Example (2)
ABC Company issued a bond with face value for $1000, Zero coupon and 5 years to
maturity, what is the value of ABC bonds today if the required rate of return is 12%.
Answer:
PV = 1000 = 1000 X 0.56743 = $ 567.43
(1.12)5

Example (3)
ABC Company issued a bond with face value for $1000, 6% Semi Annual Coupon and
2 years to maturity, what is the value of ABC bonds today if the required rate of return is
8%.
Answer:
Coupon = 1000 X 6% X ½ = $ 30
RRR (Semi Annual) = 8÷2 = 4%
PV = 30 + 30 + 30 + 30 + 1000
(1.04)1 (1.04)2 (1.04)3 (1.04)4 (1.04)4

Ordinary Annuity Table PV Table

Interest = 4% & N= 4 Interest = 4% & N= 4

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PV = 30 X 3.62990 + 1000 X 0.85480

PV = 108.90 + 854.80 = $ 963.70

Bond Yield to Maturity (YTM)

YTM is the rate of return earned on a bond held to maturity. Also called “promised
yield.”

Example (4)
14 Years bond, 10% Coupon, $ 1000 par value, bond price at $1494.93 what is rate of
interest would you earn on your investment if you held the bond till maturity?

Answer:
1494.93 = 100 + 100 + …………… + 100 + 1000
(1+r) 1 (1+r) 2
(1+r) 14 (1+r) 14

We use trail & error or Financial Calculator we reach to 5%

To proof the Result

100 x 9.89864 + 1000 x 0.50507

989.86 + 505.07 = $ 1494.93 (Which is equal to bond price)

Bond Current Yield

It is the annual interest payment divided by the bond current value

Example (5)
A bond currently sells at $ 985 and pay a coupon 10% what is the current yield?
Answer:
Current yield = 100 x 100 = 10.15%
985

Example (6)
Heath Foods’ bonds have 7 years remaining to maturity. The bonds have a face value of
$1,000 and a yield to maturity of 8 percent. They pay interest annually and have a 9
percent coupon rate. What is their current yield?

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Answer:
PV = 90 + 90 +……………… + 90 + 1000
(1.08)1 (1.08)2 (1.08)7 (1.08)7

Ordinary Annuity Table PV Table

Interest =8% & N= 7 Interest = 8% & N= 7

PV = 90 X 5.20637 + 1000 X 0.58349

PV = 468.57 + 583.49 = $ 1052.06

Current Yield = 90 X 100 = 8.55%

1052.06
Example (7)
Callaghan Motors’ bonds have 12 years remaining to maturity. Interest is paid annually,
the bonds have a $1,000 par value, and the coupon interest rate is 8 Percent. The bonds
have a yield to maturity of 9 Percent. What is the current market price of these bonds?

Answer:
Coupon = 1000 x 8% = $ 80

PV = 80 + 80 +……………… + 80 + 1000
(1.09)1 (1.09)2 (1.09)12 (1.09)12

Ordinary Annuity Table PV Table

Interest = 9% & N= 12 Interest = 9% & N= 12

PV = 80 X 7.16073 + 1000 X 0.35553

PV = 572.86 + 355.53 = $ 928.39

Assignment: (5-1) & (5-3) & (5-7) & (5-9) & (5-14)

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Challenging Example (8)
Suppose Ford Motor Company sold an issue of bonds with a 10-year maturity, a $1,000
par value, a 10 percent coupon rate, and Semiannual interest payments.

A. Two years after the bonds were issued, the going rate of interest on bonds such as
these fell to 6 percent. At what price would the bonds sell?

B. Suppose that, 2 years after the initial offering, the going interest rate had risen to 12
percent. At what price would the bonds sell?
Answer:
Coupon = 1000 x 10% X ½ = $ 50
Remaining Years till Maturity = 10 – 2 = 8 years = 8x 2 = 16 period
Interest (Paid Semi Annual) = 6÷ 2 = 3 %
A)-
PV = 50 + 50 +……………… + 50 + 1000
(1.03)1 (1.03)2 (1.03)16 (1.03)16

Ordinary Annuity Table PV Table

Interest = 3% & N= 16 Interest = 3% & N= 16

PV = 50 X 12.56110 + 1000 X 0.62317

PV = 628.06 + 623.17 = $ 1251.23

B) - Interest (Paid Semi Annual) = 12÷ 2 = 6 %

PV = 50 + 50 +……………… + 50 + 1000
(1.06)1 (1.06)2 (1.06)16 (1.06)16

Ordinary Annuity Table PV Table

Interest = 6% & N= 16 Interest = 6% & N= 16

PV = 50 X 10.1059 + 1000 X 0.39365

PV = 505.30 + 393.65 = $ 898.95

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